In his podcast last week Russ Robert’s asked why fairly sensible people are concerned about deflation. I want to answer that.

I will try to explain my point of view in an Austrian-esque way because I think that will help facilitate the discussion. Forgive me if I botch the nomenclature.

Simply put deflation or even very low rates of inflation matter because when nominal interest rates hit zero they fail to communicate the proper signals to savers and borrowers.

When interest rates are above zero, higher interest rates tell potential savers that if they refrain from consuming today that more real resources can be produced tomorrow. Higher interest rates tell potential borrowers that there is a high demand for using real resources today. Lower interest rates do the exact opposite.

There is a problem, however, when the nominal interest rate hits zero. The fact that nominal interest rates can’t get any lower destroys the power of the market to convey the right signals.

To see this its important to see why interest rates might need to go below zero to send the correct signals.

Suppose that suddenly many people became fearful about the near future. They might want to protect themselves by transferring resources from today into the near future. However, there is a limit on our physical ability to do that. For one there are a limited number of investment projects which could begin today and produce a positive return in a short amount of time.

We could try to store physical goods and services for use tomorrow, but there would be storage costs. More importantly, if we were uncertain about what the future would bring ,we might not exactly know which real resources we wanted to store and so there are costs to picking the right ones.

All of those factors mean that in order to achieve what people want – more security about the near future – there is an economic price to be paid.

If prices were working perfectly then this economic price would be reflected in a negative real interest rate.

If there is inflation in the economy then negative real interest rates can be achieved when the nominal interest rate is below the rate of inflation. The correct signals are sent between borrowers and savers and everything can work out.

If there is deflation, however, then the real interest can’t get negative because nominal interest rates can’t go below zero.

[ For my long time readers I know I made a big deal about explaining that nominal rates can and would go below zero during a severe crisis, but this piercing of the lower bound is a small phenomenon in comparison to the effects I am talking about here ]

Said again, the core problem is that  transferring real economic resources into the near future is costly but the interest rate can’t reflect that.

The reason the interest rate can’t reflect that is because at zero people can begin to hold cash as a form of savings. This doesn’t reflect any actual transfer of real resources into the future but each individual believes that it does.  Everyone thinks that because they will have more money in the near future that they can buy more in the near future. However, it can only be possible for everyone to buy more in the near future if production is higher in the near future.

Everyone is mistakenly thinking that holding cash represents “true savings” when it doesn’t.

As this everyone tries to hold more cash, consumption in virtually every cash based sector declines. Importantly, consumption in medical services shouldn’t decline because medical services are not paid for out of pocket.

This decline in most forms of consumption causes many business inventories to rise. In some sense this is what people wanted. They wanted there to be more near term investment and higher inventories are a form of investment.

The problem comes because building inventories is costly for businesses. They have to pay suppliers but they are not getting revenue. This would be fine if the savers were providing the businesses with funds to hold them over. However, the savers are not providing the businesses with funds. The savers are holding their funds as cash.

The businesses respond to increasing inventories by reducing orders to suppliers. The suppliers would then have an inventory build on their hands and so they reduce production, layoff workers and stop capital investments.

This is what we see as rising unemployment and falling capital expenditures.

This decreased production – which is the exact opposite of what people wanted – is surprising and induces even more fear about the near future and even more build up of cash.

What’s needed to stop this is for somehow the interest rate to get low enough to both convince people to save less and to induce businesses to enter into costly inventory builds. That means the real interest rate needs to be negative, which requires inflation.

Now you might ask. Why wouldn’t this always happen when there was deflation. This gets at the struggle Russ and Don had over deflation generated by rising productivity vs deflation generated by a falling money supply.

High productivity growth rates produced by advancing technology or capital deepening mean that there are plenty of ways to invest resources today that will produce more resources tomorrow. So you don’t have to worry about interest rates going negative.

However, it should be the case that a sudden drop off in productivity growth will lead to the same type of trap. The prediction of this type of story is that with a fixed money supply changes in productivity growth will produce booms and busts out of proportion with the productivity changes themselves.

Rising productivity raises the equilibrium short term real interest until the point that the loanable funds market  can clear and the economy roars to life. Drops in productivity growth drop the equilibrium short term real interest rate until the point the market can no longer clear and the economy crashes.